Dominant Currency Paradigm: A New Model for Small Open Economies
IMF Working Papers, November 22, 2017
Source details
- Canonical URL
- Dominant Currency Paradigm: A New Model for Small Open Economies
Other formats
Bibliographic details
- Authors: Camila Casas, Federico J Diez, Gita Gopinath, Pierre-Olivier Gourinchas
- Published: November 22, 2017
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484330173.001
Overview
- Most trade is invoiced in very few currencies.
- The Mundell-Fleming benchmark and its variants focus on pricing in the producer’s currency or in local currency.
- The paper models a “dominant currency paradigm” for small open economies characterized by three features: pricing in a dominant currency; pricing complementarities; and imported input use in production.
Model features
- Pricing in a dominant currency.
- Pricing complementarities.
- Imported input use in production.
Key findings and implications
- Under the dominant currency paradigm:
- (a) the terms-of-trade is stable;
- (b) dominant currency exchange rate pass-through into export and import prices is high regardless of destination or origin of goods;
- (c) exchange rate pass-through of non-dominant currencies is small;
- (d) expenditure switching occurs mostly via imports, driven by the dollar exchange rate while exports respond weakly, if at all;
- (e) strengthening of the dominant currency relative to non-dominant ones can negatively impact global trade;
- (f) optimal monetary policy targets deviations from the law of one price arising from dominant currency fluctuations, in addition to the inflation and output gap.
Empirical evidence
- Using data from Colombia the authors document strong support for the dominant currency paradigm.
Policy implications
- Optimal monetary policy should respond to:
- deviations from the law of one price arising from dominant currency fluctuations;
- traditional targets of inflation and the output gap.
- Recognition that expenditure switching occurs mostly via imports and is driven by the dollar exchange rate has implications for exchange-rate and trade policy effectiveness in small open economies.
Dominant Currency Paradigm: A New Model for Small Open Economies — By Camila Casas, Federico J Diez, Gita Gopinath, Pierre-Olivier Gourinchas; November 22, 2017; IMF Working Papers 2017, 264 (2017).
Content in this bundle
- Dominant Currency Paradigm: A New Model for Small Open Economies, WP/17/264, November 2017